New Weather Patterns

The weather risk management market has experienced explosive growth in the last few years due to increased awareness of the benefits of this kind of risk mitigation. Canadian markets have a unique opportunity to use weather risk management contracts to hedge against a myriad of weather-related factors that cause volatility in earnings.

WRMA

The Weather Risk Management Association (WRMA) is the international trade organization of the weather risk management industry. It has more than 50 members in 14 countries. Results of WRMA’s most recent annual membership survey are particularly compelling: according to the Price Waterhouse Coopers Annual Weather Market Survey, the notional value of weather risk management contracts transacted from April 2005 through March 2006 increased nearly five-fold from last year, from US$9.7 billion to US$45.2 billion (See Figure 1 on Page 26).

These numbers are a tremendous validation of the business of weather risk management. Companies are recognizing the importance of the weather market, as well as its interdependence with the commodity markets – particularly energy – and the ability to hedge commodity price risk in the weather market.

WRMA has played a key role in the growth of weather risk management as a financing instrument. The efforts of WRMA and its members in market education, regulatory framework development and legal documentation around the world have laid the foundation for this exponential growth. Through its efforts, WRMA has helped to provide greater transparency, liquidity and creditworthiness to clients in this area.

Significant growth can also be attributed to the success of the weather contracts listed on the Chicago Mercantile Exchange (CME), which have more than quadrupled in value during the survey period. Trading on the CME has grown at a staggering rate: over the past two years, volumes have increased from 4,400 contracts traded in 2002 to more than 1 million contracts traded through March 2006, as reported by the CME.

WRMA incoming president Gearid Lane, procurement director of Centrica Energy, said: “We are really pleased with the excellent growth in trading volumes. These results demonstrate that the market is reaching its full potential. In the coming years, this market will enable businesses and a wide variety of concerns to hedge more and more of the trillions of dollars of weather exposure in the world’s economies. WRMA is committed to supporting the industry in this exciting growth phase. Also, it is committed to ensuring that our Asian, European and emerging markets replicate the strong growth in North America.”

WRMA employed Price Waterhouse Coopers to conduct a survey validating the study findings through an independent third-party.

MARKET DEVELOPMENTS

The rapidly expanding volume of transactions demonstrates the growing awareness of the availability and effectiveness of weather hedging. A significant amount of the growth can be attributed to combining weather transactions with commodity transactions: this kind of pairing is more common as the transparency, liquidity and creditworthiness of the weather market increases due to strong balance sheets of dealers such as Swiss Re as well as the clearing of contracts on the CME. Moreover, companies hedging the weather volatility out of their corporate earnings find the weather hedges are becoming more affordable and easier to understand and justify. This is true for energy companies as well as agricultural companies hedging their yield or throughput risk.

Swiss Re has underwritten crop yield risk for a number of years in Canada. Grain processors and transporters are very much exposed to weather risk. By providing a yield-based product, Swiss Re absorbs the basis risk that a pure weather hedge tied to temperature and/or precipitation might provide. Further, we are seeing businesses express interest in driving sales promotions with rebates tied to weather events. A prime example would be the impact of deficient snowfall on the sale of snowmobiles or snow removal equipment. In the summer, this type of product can be tied to sales of air conditioners with a rebate tied to lower than normal summer temperatures.

Another significant Canadian exposure is tied to hydro-electricity and power prices. Hydro-electricity is the dominant power source in Canada, representing close to 60% of the nation’s power supply. It is a low-cost and environmentally friendly (emissions free) source of power. Low precipitation, both rainfall and snowfall, lead to reduced sources of hydro-electricity. This drives the need to replace power supply, either through imports or firing of thermal power capacity with its inherently higher levels of emissions.

Swiss Re helped combine weather protection for hydro-electricity producers with power prices in “quanto” structures. Quantos are structures measured in one variable and paid out in another. In the case of hydro-electricity, for example, the structure involves measuring a hydro-electricity producer’s tolerance level with respect to rainfall amounts. This is translated into a payout based on the number of inches below this level, paid in megawatts of power. Because of the temporal diversification involved with multi-year structures, hydro-electric producers frequently consider three-year or five-year structures.

RETAIL

Soon we will be entering the fall and winter season for clothing. Retailers should be aware that critical-day-count weather structures might protect lost sales. Such losses develop when snow or very cold temperatures adversely affect the important weekend sales days that lead up to Christmas.

SUMMARY

Weather risk management is rapidly expanding. In addition to increased credit-worthiness, transparency and liquidity for the customer are creating more opportunities to mitigate weather-related risk. Also, more understandable and flexible structures are in place to promote this kind of risk management.